What should Ofgem’s role be?

Once the market’s strongman, over the years the energy regulator has been buffeted by market mishaps and political meddling. Nigel Hawkins considers the implications of its eroding power base.

At one time, Ofgem was regarded as the energy industry ringmaster. But, like Test Match umpires whose role has been usurped by the “decision review system”, the energy regulator’s power base continues to erode.

In recent years, it has been relegated to being an emissary of government energy policy, transmitted via the Department of Energy and Climate Change (Decc). Several factors have conspired to cause this, including greater political intervention, climate change issues, European Union rulings and the serious shortfall in generation investment.

In effect, Ofgem has become the meat in the sandwich between a PR-obsessed coalition government and the cash-strapped energy companies, which are expected to finance much of the sector’s £100-plus billion decade-long investment programme.

Furthermore, Ofgem’s impotence on rising energy prices contrasts sharply with Labour leader Ed Miliband’s 20-month price freeze pledge. To be fair, Ofgem no longer sets retail prices in the way that Ofwat does for the water sector – and regulating parts of the international energy empires assembled by behemoths such as EDF, Eon and RWE is a very different proposition from regulating Dee Valley Water.

Nevertheless, Ofgem’s toothlessness has caused discontent.

For some, the referral of the energy sector to the Competition and Markets Authority (CMA) provides an opportunity for the privatisation settlements of the former British Gas and the electricity supply industry to be revisited. To believe that the CMA’s recommendations – even if enacted by a post-2015 government – will provide a panacea for the sector’s woes is unquestionably optimistic. Nonetheless, they may pre-empt some fundamental changes to the current system, characterised by government meddling, a big six oligopoly and a seemingly powerless Ofgem.

Leading the calls for reform are former energy regulators including professor Stephen Littlechild, who presided over Ofgem’s predecessor, Offer. Central to their concerns is the financial impact of intervention and how it may both increase costs and weaken competition.

They argue that the CMA should examine the effect of regulatory interventions on price levels and price dispersion, customer switching and customer choice, the products offered by suppliers, innovation, supplier profitability, new entrants into the market and more. More specifically, they ask whether Ofgem has a statutory locus to decide what constitute fair prices and whether they can impose them via licence conditions.

Whether the CMA addresses such issues, or indeed whether it will recommend a substantially different role for Ofgem, remains to be seen. But it is unlikely to emulate the Labour party, which supports both the abolition of Ofgem and the reintroduction of the Electricity Pool, presumably under the aegis of a successor body.

In reviewing Ofgem’s current role, it is pertinent to look at its history. Its predecessor bodies, Ofgas and Offer, were regulatory children of privatisation. Ofgas’s role was primarily to regulate British Gas. Offer presided over an industry that included generators and 12 regional electricity companies (the latter were the original shareholders of National Grid).

Transmission and distribution were, and remain, monopoly businesses that required periodic price reviews. Today, with National Grid the UK’s most valuable utility, setting the final determination for its eight-year regulatory period has arguably been Ofgem’s prime task.

Electricity supply was seen to be suitable for competition, which was progressively introduced. Nowadays, after vertical integration in the late 1990s, the big six energy companies dominate the market, similar to their supermarket counterparts – Tesco, Sainsbury’s, Asda, Morrison. But there are two major differences.

First, energy prices tend to go up rather than down. Second, there is little switching between the big six. Both issues will no doubt be probed by the CMA, given that Ofgem’s previous attempts have yielded little.

At privatisation, generation was regarded as a competitive activity. As such, Ofgem had responsibilities both to oversee the generation market, most notably the complex “pool” arrangements, but also to promote new generation.

During the 1990s, many gas-fired plants were built on the basis of better economics, . Indeed, virtually all new baseload plant was gas. The later units built at Drax in the 1980s were the last coal-fired investment of note.

Over the past decade, as the plant margin has fallen, the quest for new generation has been government-led, most obviously in the renewables space.

Currently, little new gas-fired capacity is coming on stream because of uncompetitive prices, while new coal-fired plant is precluded by environmental issues and carbon tax liabilities. Everything else, nuclear and renewables, is based on a chase for public subsidies. Without them, the proposed plant is probably unfinanceable.

The lucky winners are determined neither by the market nor by Ofgem. Instead, the Treasury generally decides.

The decision, such as guaranteeing a 35-year £92.50p/MWh price for Hinkley Point C, is then conveyed to the public via Decc.

Such scenarios inevitably leave Ofgem with a much reduced role. Of course, it has many minor responsibilities, including setting industry standards and handling consumer complaints, which could be parcelled out to others, but unquestionably Ofgem is no longer the sector ringmaster.

And its case for remaining in the energy circus has seldom been weaker.

Nigel Hawkins, director of investment and policy research firm Nigel Hawkins Associates